Shorting For-Profit Colleges: Profiting From the Subprime Arena of the Education Sector

As I stated in my previous column about student loans, America is experiencing a bubble in higher education. Universities across America will be victim to severe cutbacks, declines in enrollment, and student loan defaults. For-profit colleges such as the University of Phoenix, DeVry, and ITT Tech suffer the greatest risk of anyone outside of Sallie Mae of a student loan collapse.

Although companies such as the Apollo Group (NASDAQ:APOL), DeVry Inc. (NYSE:DV), and ITT Corporation (NYSE:ESI), have strong balance sheets with little debt and 20% plus returns on investment capital, underlying fundamental problems will bring them down. Due to the demographics of its students, the lack of credibility of the institutions, and defaults and stricter government backed student loans, for-profit colleges are an excellent short opportunity.

The primary weaknesses of for-profit colleges is the weakening and regulation of the student loan market. On average, 90% of for-profit colleges' revenue comes from government backed student loans. The Obama administration has begun to crack down on the issuing of government backed student loans, by directly issuing loans instead of allowing them to pass through private banks and mediators such as Sallie Mae.

Regulation is expected to increase and may cost the schools the right for private aid. Washington is already criticizing for-profit schools for manipulating default records, and revocation of the right to book loans under federal aid would greatly diminish the size of future classes. Currently the default rate is already 25% for for-profit institutions versus the 13.8% average for colleges and universities as a whole. As a result, the risk of losing federal aid status is real and will likely happen if default rates continue to inch up.

Demographics and the schools' relationship to the job market also hurt the prospects of for-profit colleges. First, the demographic trends: many of the students of these schools come from a low income background which often includes a history of dropping out of college previously. This trend can be seen in the University of Phoenix graduation rate of 16% for 2010. In an already tight employment market, these schools lack credibility within the job market. As a result, many of the students who attend these colleges face unemployment or the same low income jobs they had before enrolling. However, they now have $50,000+ of student loan debt added to their financial problems.

The trends above effect all of the schools, but here are some brief insights into individual companies in the sector:

Apollo Group (APOL)- Apollo Group owns the University of Phoenix which is the largest franchise among the for-profit colleges. They also have the largest downside. Even with recent regulation combating this issue, Apollo invests significantly more capital and commitment towards recruiting students over the educational quality of its programs. Most of its teaching staff is slotted into low paying part time positions which does not encourage talented faculty to work there. Financially the company is still very healthy, but may be weakening with earnings expected to decline even before factoring in the risk of student loan regulation.

DeVry University (DV)- DeVry is the third largest for-profit college in the United States. It is the healthiest financially, has the strongest accrediation, and has the least negative track record of the three for-profit colleges mentioned on this list. Nevertheless, the education quality and reputation is just as weak as that of the University of Phoenix and ITT Tech.

ITT Educational (ESI)- ITT is the fourth largest for profit college in the US and specializes in two to four year undergraduate degrees in more technical fields. ITT is not regionally accredited and the company even warns potential students that ITT credits are not transferable to other universities. Within a sector that already has credibility issues, ITT is the laggard in terms of academic standards. Its two year degree is also not price competitive as it costs over ten times the amount of a traditional community college ($47,328 vs. $4,720). Financially, ITT has the highest debt levels of the three companies with a 1.86 debt to equity ratio, which makes solvency more of an issue versus competitors.

Overall, I expect fundamental issues such as student loans and the lack of return on investment of students' degrees to ultimately undo the success of Apollo, DeVry, and ITT. These problems are widespread and all three companies mentioned are in weak shape in the long run. On a technical basis, these companies also have recent island gap reversals up which is a strongly bearish signal. This is not a short term trade as it may take a few years for student loan defaults and negative career prospects for graduates to grow to a rate that scares regulators and future prospective students.

Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in APOL, ESI over the next 72 hours.

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